Why Government Bailouts Actually Lower GDP Growth Potential

What does it take to create and sustain long-term gross domestic product (GDP) growth in an economy?

One of the most important factors is a high level of investor confidence.

Investor
confidence throughout the economy can help support the formation and
expansion of businesses and the development of new technologies and
ideas.

GDP growth,
as we all know, does not originate from government-led initiatives, but
from businesses creating new innovations and technologies.

One of
the problems with government intervention is that GDP growth is
actually stifled and reduced due to a misallocation of resources. This
misallocation of resources occurs when weak firms are supported or
bailed out due to poor management decisions.

The funds allocated
to support weak or underperforming companies are then unable to flow
into stronger corporations that can expand, innovate, and make the
economy fundamentally stronger, lowering GDP growth potential and
ultimately weakening investor confidence.

Over the last few years
following the financial crisis, many have thought about ways to prevent
such an outcome. One of the more original writers of our time is Nassim
Nicholas Taleb.

Author of the famous books Black Swan and Antifragile
(both of which I highly recommend), Taleb recently suggested several
ideas, with which I completely agree, to reduce the possibility of
another financial crisis, while helping restore investor confidence.

One
of the most interesting ideas I’ve heard to restore investor confidence
is to remove the incentive for firms to become too big to fail. Instead
of forcing companies to be broken up, Taleb suggests that any firm
deemed “too big to fail” should pay its staff no more than a
corresponding civil servant. (Source: “From Fat Tails to Fat Tony,” The Economist via The World in 2013, last accessed January 15, 2013.)

According
to Taleb, since the government is effectively backing the company, the
firm is essentially an extension of the government and should not pay
employees any higher wages than other government workers.

Another
good idea from Taleb that would help restore investor confidence and
long-term GDP growth is that any person who becomes a politician should
never earn more than a set amount from the private sector, meaning no
massive payday.

As it stands right now, politicians have the huge
incentive to create favorable conditions for a company that they might
join upon leaving politics. This can lead to a massive misallocation of
capital that favors companies that will grant guaranteed bonuses and
jobs to politicians; not what’s best for the economy.

Any time an economic decision is not optimal for the economy, potential GDP growth levels will decline and investor confidence will weaken.

One
idea that Taleb suggests, which I have supported for some time, is that
the “value-at-risk” calculation should be banned. The problem with
trying to calculate risks in such a manner is that they underestimate
the possibility of massive moves.

By creating a
lower-than-expected probability of an extreme event, the risk manager
assumes false confidence. This leads to higher levels of risk-taking,
making the entire system more fragile.

The core to all these ideas
is not changing how humans act, since that’s not possible, but working
with our human traits. This is something that I’ve suggested for a long
time: creating an incentive and disincentive structure for all major
human activities.

For an economy to generate strong, long-term GDP
growth, we need to incentivize people in the proper areas. This will
create a high level of investor confidence in the knowledge that the
funds allocated to various businesses are being used in the best
possible way.

Investor confidence has waned over the last few
years due to the inexcusable level of uncertainty throughout the
economy. Business owners are constantly unsure of how politicians will
act. Plus, there’s the structural fragility of some parts of the economy
due to government intervention and bailouts.

Sustainable GDP
growth has to be built on a solid foundation. This means that businesses
that are truly innovative will have capital flowing into them that’s
not based on bureaucratic intervention.

Risks to the entire
economy need to be systematically reduced by creating natural
disincentives to government bailouts. We can’t have it both ways; the
company managers can’t take risks if they are not willing to bear the
losses.

This type of structural reform, I’m afraid, is not likely
to occur anytime soon. With so much of the infrastructure embedded, this
naturally will lower GDP growth potential for the economy.

For
now, all we can hope for is a lower level of government intrusion to
help restore investor confidence and to at least try to improve GDP
growth levels to a sustained level.

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